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Texas courts are effectively ignoring the legislature’s command that restraints of trade or commerce are illegal

It is a mandatory ritual for judicial candidates in Texas to recite that “a judge’s job is to interpret the law, not make the law.” Thoughtful lawyers who actually handle litigation know this statement is wrong (or at least overly simplistic), but that’s a thorny subject for another day. The point this week is that Texas courts are sidestepping the legislature’s command that restraints of trade or commerce are illegal. The recent federal district court decision Connell v. Wells Fargo illustrates the problem.[1]

Texas has a statute that says every contract in restraint of trade or commerce is unlawful.[2] The statute has an exception that says a “covenant not to compete”—I’ll call it a “non-compete” for short—is enforceable if it meets certain requirements.[3] Thus, enforcement of non-competes is supposed to be the exception, not the rule.

This doesn’t mean non-competes are always bad or always unenforceable. Sometimes I represent the employee; sometimes I represent the employer. As I discussed here, whether a non-compete is enforceable always depends on the circumstances.

Arguing that a restraint on competition is not a “non-compete” can be jumping out of the frying pan into the fire

Sometimes, when an employer wants to avoid the requirements of the non-compete statute, it will argue that the restraint at issue is enforceable because it is not really a non-compete. But there’s an obvious problem with this argument. If an agreement restrains competition but is not a “non-compete,” it is still a restraint of trade. If it’s a restraint of trade but not a non-compete, then the statute says it is unlawful. So, by trying to avoid the requirements of the non-compete statute, the employer can jump out of the frying pan straight into the fire.

Or at least, that’s the way Texas courts should look at it. The Texas Supreme Court doesn’t always see it this way.

In Exxon Mobil v. Drennen, the Texas Supreme Court addressed a contract that required a former employee to forfeit a significant amount of unvested compensation if he decided to compete with his former employer. The key legal issue was whether the agreement was a non-compete or not.[4]

Let’s pause here. In most areas of the law, courts focus on the actual function of a contractual provision, rather than what the parties label it. In other words, courts typically focus on substance rather than form to decide whether a certain legal principle applies. For example, let’s say the legal principle is that an agreement to pay a real estate commission must be in writing. A real estate agent could not avoid this principle simply by labeling the compensation a “bonus” rather than a “commission.” That would be silly.

So, you would think that a court would determine whether a contract is a “non-compete” by asking whether the contract serves the function of restraining or discouraging the employee from competing with the employer. In other words, you would think a court would put substance over form. But you would be wrong.

Exxon Mobil v. Drennen elevated form over substance

In Drennen, the Texas Supreme Court put form over substance by holding that a forfeiture clause triggered by an employee competing with the employer is not a non-compete. For the reasons explained above, I think this was wrong. Again, I’m not necessarily saying the agreement was unfair or unenforceable, just that this kind of forfeiture clause obviously functions as a non-compete and should be evaluated as such.

But then the Texas Supreme Court compounded the error with a second mistake. It declined to consider whether the forfeiture clause was an unlawful restraint on trade or commerce.

As explained above, if an agreement restrains trade or commerce but is not a “non-compete,” then it falls under the general rule for restraints of trade, rather than the exception for non-competes. It would then be unlawful and contrary to Texas public policy. But the Drennen court punted on this issue, refusing to decide whether a forfeiture clause that restrains competition is an unlawful restraint of trade.[5]

This was also a mistake. Drennen should have decided the issue rather than punting, and the effect of Drennen’s error is apparent in the recent Connell v. Wells Fargo case. The plaintiffs in Connell argued that a forfeiture clause in their contracts violated a fundamental Texas policy because either (a) it was an unenforceable non-compete, or (b) it was an unenforceable restraint of trade. The federal district court disagreed. Under Drennen, the court said, a forfeiture of unvested compensation is not a non-compete.

But was the forfeiture clause an unlawful restraint of trade? The Connell court rejected this argument also, reasoning that (a) the Texas Supreme Court declined to decide this issue in Drennen, and (b) Drennen held that Texas has no “fundamental policy” against such clauses, even if Texas courts might eventually find that they are unlawful.

Connell v. Wells Fargo followed Drennen

So let me get this straight. A forfeiture clause that restrains competition but is not a “non-compete” might be unlawful under Texas law, but even if it is unlawful, it doesn’t implicate any fundamental Texas policy?

It’s hard to fault the district court in Connell for applying Texas law as expressed pretty clearly in Drennen, but something is wrong here. If Texas courts are going to allow employers to avoid application of the non-compete statute by arguing that a non-compete is not really a non-compete, then Texas courts should at least consider whether the agreement is instead a restraint of trade prohibited by the legislature.

These are his opinions, not the opinions of his firm or clients, so don’t cite part of this post against him in an actual case. Every case is different, so don’t rely on this post as legal advice for your case.

[5]Drennen was able to avoid the issue because the question was whether the clause violated a “fundamental policy” of Texas for choice-of-law purposes. The contract in Drennen selected New York law, which allows the kind of forfeiture clause at issue. I previously wrote about Texas choice of law principles for non-competes in This Stuff’s Made in New York City!